Surplus cash

[Margo2023]

I see a lot of advice to put spare cash into pension first before overpaying mortgage or putting into savings. I'm trying to understand this advice better. I must admit I am pretty clueless with pension and it's on my list to gain more knowledge there. My question is, should I be paying any more into my pension than I am currently paying (instead of sticking money into mortgage overpayment and savings)? Some background:

Single 37, no children
Salary £60k
Current monthly payment to pension £500 (this is the total inc, employer matched)
Got an Isa - not maxed out but close to

Thanks!

That advice is overly simplistic. The 'best' option will vary for different people, at different times, and depending on the wider economy.

As a general rule, savings should come first - provided you're covering the basic mortgage payments and have no other debt. Once you have a reasonable amount of savings ('reasonable' can be anywhere between 3 months and a couple of years, depending on circumstances) you can think about investments that will earn more than the interest you can get in the bank.

That can be investment in the asset you live in (your house), pensions, or other investments such as stocks and shares ISAs, and potentially things like buy-to-let, vintage wines, venture capital or whatever. But let's ignore those for now.

Paying extra on the mortgage as your first choice makes emotional sense by increasing your sense of security. It makes sense in terms of medium term cash flow, by decreasing the time you're stuck with a fixed outgoing. And it can make overall financial sense if the interest you're paying on the mortgage is higher than what you could earn on savings or other investments.

So at the moment overpaying the mortgage looks reasonable if you're on a newer, rising interest rate. In the late 80s/early 90s when mortgage rates could be close to 15% and the best savings account was about 10%, and people were still skittish about stocks after the '87 crash, overpaying seemed an excellent option. But 5 years ago when you could get a mortgage for not much over 1%, it wasn't necessarily the best use of money if you could get 5% in the stock market.

So it's a matter of weighing up the return of the different options, and the other risks and benefits beyond the headline percentage.

And those other benefits are a big factor in why many people recommend pensions instead of mortgage. Long term average stock market returns are 7ish%, so you could expect roughly that growth on money in a pension (defined benefit public sector pensions are a very different animal, so I'm not including those). A bit above current mortgage rates. But when you pay money into a pension it immediately grows by at least 20% - the second it lands in the pension. More if there's an employer match, more if you're a higher rate tax payer, and more still if it's salary sacrifice so you save national insurance as well as tax. And then that money also grows.

On the downsides, unlike a house you can't live in your pension. The stock market tends to be more volatile than house prices. The money is locked away until you're at least 55, soon to be 57, whereas a repaid mortgage might free up extra spending money before that. And some of the tax saved on the way in will be paid on the way out.

As a higher rate taxpayer, if you pay £100 extra into your mortgage out of your taxed income you have £100 less to spend, and your mortgage is £100 smaller.

If you want to put £100 into your pension (assuming a salary sacrifice defined contribition pension and no employer match), your pension goes up by £100. But you've not paid tax or national insurance on that, so the reduction in your take home pay is only £58. Or to look at it the other way round giving up £100 of take home pay would mean around £170 extra in the pension.

Essentially it is the tax relief on the pension that makes a difference. You are a higher rate tax payer so you can get an extra 40% each time you make a pension contribution and then you get the growth on that. If you put it towards your mortgage you are just saving the interest on that e.g 5% each year.

A combination of both is often best, but it isn't simple. I am close to the end of my mortgage and have both overpaid and have put more towards my pension over the years. Looking back at the stage I am right now i.e. far more concerned about what my lifestyle will be in retirement I wish I tilted it more towards pension.

However, if I had totally taken that approach I wouldn't have managed to move house where having a sufficient deposit and equity were necessary. Also I know I will be delighted when I finally clear the mortgage and having fewer worries if I lose my job in future will be good!

Your financial priorities are different to those of a couple, - your lifestyle and housing are entirely dependent on that one income coming in. I would examine your situation in those terms, mitigating the short term risks of losing income first, then medium and long term risks.

1.Your immediate and short term risks to your income
-inability to work and/or drive due to illness or injury;

-redundancy;
-serious illness of a family member such as a parent or sibling leading to caring responsibilities in the short term.
Most people will encounter one or more of these at some point across their working life.

Protect your income and mitigate the risk by buying income protection, or building a large emergency buffer of 2+ years of basic needs in cash /ISA savings, or a combination of the two.
Consider private health insurance.

2.Medium term risks to income and lifestyle:
-Developing a longer term health condition or disability that affects ability to work or requires reduced hours or responsibilities.
-inability to service the mortgage or remortgage due to changes in eligibility criteria/ interest rates, changes in income/ professional role.

Mitigate these risks by reducing essential household fixed costs in the medium term by paying off the mortgage.

3.Longer term risks:
-Protect income into old age by building a substantial pension pot, and minimising housing costs.

Whilst it might make financial sense on paper to opt to pay more into a pension rather than pay off the mortgage, you can't access the pension if catastrophe strikes and you are stranded with no, or very little, income. The mortgage debt increases your risk as a single person in a way that doesn't apply to the same extent to a couple. A fully paid off house can be sold and liquidated to allow you to downsize and release funds if circumstances change to a significant degree.

You could consider a SIPP. You would get some tax back and it's potentially possible to access it before pension age, plus the sooner you put it in the longer it has to perform. Both of my DC in their 20s have some money in SIPPs on top of company pensions and mortgages.